Derivatives are financial products or securities that derive their value from the value of an underlying asset. The most common underlying assets include stocks, bonds, commodities, interest rates, and currencies. Examples are interest rate swaps, options contracts, insurance contracts, futures contracts, credit default swaps, and structured debt contracts.

The derivatives market is ten times bigger than the annual GDP of the entire world! The Bank for International Settlements reported that the over-the-counter derivatives market amounted to about $638 trillion in 2012. Author Paul Wilmott, who has written several books on this topic, estimates the global derivatives market to be much larger, $1.2 quadrillion. By comparison, the annual Gross Domestic Product of the entire world is only $65 trillion, and the total value of the United States stock market is estimated at $23 trillion (Source: The Economist magazine).

The staggering size of the derivatives market explains why billionaire investor Warren Buffet has called them “weapons of financial mass destruction.” Derivatives can result in large losses because they use leverage, which allows investors to earn large profits or losses based on small changes in the price of the underlying asset. Leverage makes it possible to earn very large profits or losses from relatively small investments.

WHY DERIVATIVES ARE DANGEROUS

Derivatives pose a serious threat to the entire worldwide financial system because large losses coming from these leveraged investments could quickly become too large for financial institutions to cover. The failure of any financial institutions would be painful, but the failure of very large financial institutions, often referred to as “too big to fail”, could take down the entire world financial system. The collapse of any of these institutions could start a domino-like collapse of other institutions until the entire system is destroyed.

It's Interesting...

Portfolio insurance is a method of hedging a portfolio of stocks against the market risk by short selling stock index futures.
This hedging technique is frequently used by institutional investors when the market direction is uncertain or volatile. Short selling...